“Seven hundred and fifty grand, huh? It’s not a song—it’s an opera.”
—Dorian Harewood, Pacific Heights
Knowing you want to buy a home is one thing; knowing what you can pay for is quite another. Too often, dreams and reality collide: You’re yearning for a four-bedroom Colonial, but your wallet can handle only a two-bedroom bungalow.
So how do you find that happy medium: a home you love that’s within financial reach? Not surprisingly, this hinges on how much money you’re pulling in.
“The general rule of thumb is that you can purchase a home that costs two or three times your annual salary,” says Harrine Freeman, a financial expert and the owner of H.E. Freeman Enterprises.
So if you’re making $80,000 per year (and you have a reasonable amount of job security), that means you can afford a home of up to three times that, or $240,000. That said, “This is only an estimate and does not account for your monthly bills,” says Freeman. So let’s dive into the specifics.
Follow the 28/36 rule
If you’re overwhelmed by numbers, budgets, and big-ticket decisions, follow the 28/36 rule, a simple but effective guide for affordability. The “28” refers to your monthly housing payments—including your mortgage payment, insurance, HOA fees and property taxes—which shouldn’t be more than 28% of your gross monthly income (ideally, it should be less). This is easy to calculate, because all you need to do is
multiply. For example, if your gross monthly income (meaning before taxes are taken out) is $6,000, multiply that by 28% (or 0.28), and that means you shouldn’t pay more than $1,680 a month for your home.
The “36” refers to your debt-to-income ratio, which compares how much money you owe each month due to debt and debtlike obligations (e.g., on credit cards, student loans, car loans, alimony, child support, and— hopefully soon—your mortgage home loan) to your monthly income (pretax). This ratio should be “no more than 36%,” says Freeman; ideally, it should be much less.
Think about it in terms of your monthly expenses: If you make $6,000 per month but spend $500 per month paying off debts, you divide $500 by $6,000, to get a debt-to-income ratio of 8.3%. This is great, but adding $1,680 per month in mortgage payments would push up your monthly debt load to $2,180, and your debt-to-income ratio to 36.3%.
This is exactly the maximum experts say you can afford. Going past this threshold is a risky move.
This is why it’s important to know exactly what your mortgage payments will amount to every month, which can be calculated with the Realtor.com Mortgage Calculator. But remember—these are estimates and rules of thumb; lenders will sharpen the pencil and apply their own policies and particulars to these general guidelines.
Apply for mortgage pre-approval
Another way to get a sense of how much home you can afford is to approach a lender and apply for mortgage pre-approval. That’s where the lender will take a look at your financial past and present circumstances to determine how much money it is willing to lend you to buy a particular home.
Just keep in mind that pre-approval is different from and more rigorous than a pre-qualification. Mortgage pre-qualification typically entails a
basic overview of a borrower’s ability to get a loan. You provide a mortgage lender with information—about your income, assets, debts, and credit—but you generally don’t need to produce any paperwork to back it up, nor do you typically need to submit an actual loan application. As such, pre-qualification is relatively easy and can be a fast way to get an initial ballpark estimate of what you can borrow and how much home you can afford. But it’s by no means a guarantee that you’ll actually get approved for a loan, or that amount of loan, when you go to buy a home.
Getting pre-approved, in contrast, is an in-depth process that typically involves submitting a loan application and a lender running a credit check and verifying your income and assets. Then an underwriter does a preliminary review of your financial situation, and, if all goes well, issues a written commitment for mortgage financing for a particular property and up to a certain loan amount; this commitment typically is good for up to 90 or 120 days but will have certain conditions attached (e.g., that an appraisal of the home will be roughly equivalent to the purchase price you would be agreeing to pay).
Moreover, getting pre-approved is often free, although there can be loan application fees or other costs depending on your lender. Expect it to take, on average, one to three days for your application to be processed. Added bonus: Mortgage pre-approval makes you a more attractive homebuyer to sellers, since they know you have financing to back up your offer.
One last thing: Beware of jargon from different mortgage brokers or lenders. Sometimes “pre-approvals” are offered that, when you look under the hood, are actually closer to pre-qualifications.
Factor in closing costs
Closing costs are fees additional to the home’s purchase price that are paid to the seller or third parties (typically at closing) that help facilitate
the sale of a home, and they can vary (sometimes widely) by geographic location. But as a rule, you can estimate that they typically total 2% to 7% of the home’s purchase price. So on a $250,000 home, your closing costs could amount to anything from $5,000 to $17,500. Yep, that’s one heck of a wide range!
Both buyers and sellers typically pitch in on closing costs, but buyers shoulder the lion’s share of the load (3% to 4% of the home’s price) compared with sellers (1% to 3%). Homebuyers pay the majority of closing costs, since many of these fees are associated with the mortgage.
Here are some of the fees homebuyers should brace themselves to pay:
- A loan origination fee, which lenders charge for processing the paperwork for your loan
- A fee for running your credit report
- A fee for the underwriter, who assesses your creditworthiness
- A fee for the appraisal of the home, to make sure its value matches up with the purchase price you are agreeing to pay
- A fee for the home inspection, which checks the home for potential problems, from cracks in the foundation to a leaky roof
- A fee for a title search to unearth any liens on the property that
could interfere with your ownership of it
- A survey fee, if it’s a single-family home or townhome (but not condos)
- Taxes, also called stamp taxes, on the money you’ve borrowed for your home loan
To estimate your closing costs, plug your numbers into an online closing costs calculator, or ask your real estate agent, lender, or mortgage broker for a more accurate estimate. At least three days before closing, a lender is required by federal law to send buyers a closing disclosure that outlines those costs once again.
Consider your dreams and the alternatives
Once you’ve determined how much home you can afford, you can start weighing what you absolutely must have in your home—and what you’re willing to sacrifice if necessary. Use the “Pick 2” rule: price, quality, location. Typically, you can prioritize two of those categories, but not all three. Your best bet is to stick to an amazing neighborhood for an amazing low price, and know that your home might not have that pool, wine cellar, or other amenities you’d hoped for.
These trade-offs are just the reality most of us face, of house hunting with less than unlimited resources, so don’t be disheartened. Consider widening your search to different neighborhoods or knocking a few items off your must-have list until you find the location and amenities that best fit your budget and priorities. Weigh what really matters for your dream home, then start performing preliminary searches online using sites such as Realtor.com. And try to stay optimistic—with enough searching, and maybe some luck, you might be able to find it all.
Once you’ve determined what kind of home you’re looking for, it’s time to put your feet to the pavement and start checking out the market in person. To do that, you’ll probably want help from me, Steve Wilson and my team. We will take you out to properties that fit your criteria and guide you to the home of your dreams.
